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The next stage in the exchange-traded-fund revolution is starting to seem like the announcement of a rock 'n' roll comeback tour. You've got the familiar names and faces. They generate a robust mix of excitement and trepidation, and no small amount of skepticism regarding the new release. Actively managed ETFs have been waiting in the wings for several years. There's $1.5 trillion invested in nearly 1,500 exchange-traded funds, notes, and related investments, but nearly half of that -- 47% -- is in just 25 funds, most of which track the broadest benchmarks. Less conventional approaches to indexing -- such as those accounting for valuation metrics, dividends, demographic data, or volatility -- are also gaining popularity, a group that looks suspiciously like active management in the guise of a quantitative, or rules-based, ETF. But true active management has yet to take center stage.

There are several hurdles to overcome: Many managers are worried that intraday pricing and daily disclosure of portfolio holdings will lead to front-running. There are also issues around derivatives usage. And not all fund firms are in a rush to launch cheaper or copycat iterations of established funds.

But many industry observers are convinced 2013 is the year active ETFs will hit the big time. So Barron's convened a panel to tell us how they see the industry evolving, what the roadblocks are, and whether investors will just be hearing the same old song.

Vineer Bhansali is a managing director at Pimco; he holds a Ph.D. in theoretical particle physics from Harvard and oversees the firm's quantitative investment portfolios. About 60% of all the money in all actively managed ETFs is in Pimco products.

Stephen Clarke is president of Navigate Fund Solutions, the unit of Boston-based asset manager Eaton Vance that is spearheading an effort to create a new breed of ETF -- an exchange-traded managed fund. ETMFs would be a kind of hybrid of an ETF and a mutual fund, whose portfolio disclosures would be less complete than traditional ETFs. Eaton Vance currently has no exchange-traded funds on the market.

Barrons:What's the appeal of an actively managed fund? Investors have largely been attracted to ETFs in an effort to avoid someone else's active management.

Bhansali: Equity-fund managers have underperformed. But there are people with skill who can beat the market. Pimco has bond managers with long track records; there are people in equities, too, who can outperform.

So an actively managed ETF needs a manager with a good, long-term track record.

Bhansali: Not only a performance track record, but the ability to communicate to your investors how it was done, and why it is being done. There are macroeconomic forces right now that haven't been in play for 70 or 80 years. There are active decisions being made by central bankers and policy makers -- I don't want to use the word manipulate, but that's what it is -- to manipulate asset prices. Investors who stick with index ETFs because they represent the broader market are likely to be disappointed.

So your argument is that investors can't afford to be solely passive. What else?

Faber: Investors don't need a 10th sector fund. But there is a huge opportunity for hedge-fund-like strategies and indexes. The managed futures space, for instance, is incredibly ripe for disruption.

Clarke:Active management can move to a more cost-efficient structure. We're going to continue to see the trend of investors seeking lower costs and more tax-efficient structures. That will be true whether it's an active or passive strategy.

Dickson: There may be ways to do in the alternative space what indexing did for stock and bond markets 40 years ago. Think of something like a currency carry trade. You can implement the strategy at a very low cost. Merger arbitrage strategies is another example.

Faber: We think the currency market is one of the biggest opportunities of the next 15 years. It is an asset class that Americans don't think about very much. They think about stocks and bonds.

So the actively managed ETF is a place to deliver overlooked or underappreciated alternative strategies.

Johnson: ETFs have accelerated the mainstreaming of different assets and strategies. But people are very used to thinking in 60-40 terms, stocks and bonds.

Bhansali: There are specific alternative strategies that have been sitting in hedge funds where people can now say, "That's what I was paying for? It is so easy I can replicate it myself." But replicating it is not the same as sticking it into an index fund and cranking the machine. You have to be smart about it.

Any other appeal of active ETFs?

Faber: Transparency. Don't forget the very real, personal, mental anguish once people realize what their broker sold them: the conflicts of interest, loads, and ridiculously high fees. Once people realize how they've been screwed for the past 30 years, that's a one-way street. The money won't flow back to high-cost mutual funds. The same should be true for hedge funds.

Stephen Clarke of Eaton Vance is working on a new kind of actively managed fund that will allow portfolio managers to hold off disclosing holdings they're currently trading.
Ken Schles for Barron's

Also, for us, the real benefit of an ETF is not so much the intraday trading as it is the tax advantages, which are enormous versus an active equity mutual fund or hedge fund. [More on that soon.]

So what does the future look like for actively managed ETFs?

Dickson: In many ways, ETFs crossed the active Rubicon years ago. Because of regulatory constraints, the index universe re-branded itself. It now creates indexes out of actively managed strategies. Take a quantitative valuation approach. Call it "fundamental weighting." Create an index out of it. Now it is classified as indexing, when really in many ways it is just an actively managed strategy that is locked down every month or every quarter and held constant through that period. The place to look is the billions upon billions of dollars invested in active indexing strategies in ETF form.

You're saying that there are lots of active strategies already -- they're simply being called something else.

Johnson: The ETF managed portfolio space is also worth watching. At the end of the year, there was about $63 billion in assets in portfolios tracked by our database. That's just shy of five times the amount of assets held in what's usually called "active ETFs." This area grew about 60% last year. I think this is something that has legs.

You're referring to advisors using passive ETFs to build an active portfolio -- sometimes very active.

Johnson: I think the active use of exchange-traded funds is a much bigger story than actively managed ETFs.

Dickson: I completely agree. Advisors and managers are using passive products in a way that has changed or at least modified the definition of active management. For the end investor, the degree of active management may actually be the same. I don't know that investors have fully grasped the difference. They say, "I'm taking manager risk out of the equation by using passive products." Well, not really. You just substituted one form of manager risk for another.

Johnson: The far end of the active spectrum has actively managed products like Pimco Total Return. In between Pimco's managers and the plain-vanilla passive fund are shades of gray. In certain cases, there is real investment merit there. In other cases, it is the one back-test that survived, while hundreds of others were tossed out. You have to be wary of back-testing [used to validate a new ETF's strategy].

What distinguishes the good from the bad?

Johnson: There are certain risk premiums that have stood the test of time, like value investing. Or momentum investing, assuming it can be done at a reasonable cost. You look at the biggest anomalies. Low volatility funds -- there is real investment merit there. But for every one of that handful of persistent risk premiums, there are others flung at the wall that will probably not stick.

Clarke: Most investors, including professionals, chase performance. Many active or alternative strategies don't look like such great ideas when the world is doing fine, and a 60-40 portfolio is chugging along. Of course, people usually rush into these at the wrong time, when things are already going south.

Once you have an idea that you think sticks, how do you go about building a new ETF?

Bhansali: The suitability of the ETF for our clients is always first. The stability of the structure is key. So is the question of whether it would sell. In the low-rate environment, with most indexes tilted heavily toward developed-market governments, we wanted to move toward an active portfolio. To construct a good portfolio today, you have to look at all the individual pieces. What equity-market factors will I have? How much duration risk will I have? How many different kinds of risks will I have?

Dickson: We tend to be believers in big building blocks. Active ETFs are interesting, and certainly we could do something. Or we might not. I see active ETFs not so much as an investment play, but as a distribution play. You've got old-line mutual-fund cost structures that emerged from traditional commission-based selling platforms. But there has been a huge shift toward fee-based platforms. From a distribution standpoint, there is a lot of runway for active ETFs.

Joel Dickson of Vanguard points to a problem few have raised and no one has solved: What to do when an active ETF gets big enough you want to close it to new investors.
Ken Schles for Barron's

Could there be an actively managed Vanguard ETF?

Dickson: The biggest hurdle for us has been, and continues to be, the condition of portfolio-holdings transparency. But more broadly, what's the endgame with an active exchange-traded fund? Let's say you are successful. You need a high-capacity product to even think about doing this. At Vanguard and many other shops, when capacity limits have been reached, you close the fund. What does it mean to close an ETF? We've seen what happens when you cut off share creation -- you get a premium and a lot of volatility. That is not well understood by investors. They don't understand how the arbitrage mechanism breaks down. [For more on that, see "The Biggest Hurdle,".] I think that's an interesting question in actively managed ETFs. How are shareholders served if you are successful -- too successful -- with the product?

Morningstar's Ben Johnson points to a multitude of advisors using passive ETFs to execute active strategies.
Ken Schles for Barron's

Meaning successful, relative to what the fund can handle?

Dickson: In the traditional mutual fund, even if you close the fund, investors can get their money back at the fund's net asset value. The same is not true in an ETF.

So it turns into a closed-end fund?

Dickson: Not quite. The usual ETF arbitrage can take place when shareholders are redeeming. But that's not true on the creation side, so you'll get a premium. Most closed-end funds go to a discount.

Bhansali: It's about scalability. Our Total Return mutual fund has about $293 billion in assets, and it is actively managed. This area is scalable. Money markets are another example. But if you select an exotic strategy, you might have to close it down if it gets too big.

Does the Securities and Exchange Commission's recent removal of a ban on derivatives help the launch of new actively managed ETFs?

Dickson: Yes, though there are two big SEC hurdles to clear. The derivatives-moratorium removal makes one easier. However, there is still an additional relief needed to list an actively managed ETF on the exchange. Having a large amount of derivatives in the portfolio can delay this part. It's still a slow process for derivative-based active ETFs.

Bhansali: The Pimco Total Return mutual fund uses derivatives. There was a concern that the Pimco Total Return ETF might be hurt by its lack of derivatives. We quantified it. We determined derivatives weren't actually giving that much value. Derivatives are a tool. The success of a fund shouldn't depend on what instruments you are allowed to use.

Is the active ETF area simply a place where mutual-fund managers will repackage existing strategies?

Clarke: As of the end of 2012, there was approximately $8 trillion in actively managed mutual funds. The overwhelming majority of those assets haven't moved over to a more efficient structure, but they could.

Why haven't those active mutual funds created ETF iterations?

Clarke: The current requirement that active ETFs be fully transparent on a daily basis is one reason. But the cost and tax efficiencies of the ETF structure are still very beneficial for investors, and will encourage more development.

At the end of the day, says Meb Faber, investors' biggest hurdle is themselves.
Ken Schles for Barron's

Explain the cost advantages.

Clarke: In the case of the mutual fund, an investor delivers cash to the fund, and the portfolio manager puts it to work buying securities, which incurs trading costs. When shareholders are looking for liquidity from the fund, the portfolio manager has to sell securities to raise cash. The costs of the trading activity are born pro rata by the other investors in the fund. Those costs can be north of 70 basis points [0.7%], on average, for an equity fund annually, academic research suggests. This shows up in the returns. ETFs, on the other hand, because they create and redeem in kind [institutional investors are able to exchange the stocks held by an ETF for a new "creation unit," and vice versa], they generally don't have costs associated with accommodating shareholder liquidity. Individual traders bear their own trading costs, and long-term investors are insulated. ETFs also have very straightforward record-keeping requirements and transfer agency costs.

Do the tax advantages have special significance for actively managed ETFs?

Clarke: We think there is a performance improvement of 50 basis points [0.5%] or more to be gained annually by active managers who access the ETF's cost and tax efficiencies. That's a very attractive benefit, but you still have to submit to the portfolio transparency rules.

Is portfolio transparency that big of a stumbling block?

Bhansali: For a manager, I don't think disclosure of positions matters much, especially when the track record of an active manager isn't that great. Eventually, it is the ability to deliver performance that will dominate. This is what Bill Gross has been saying for a long time. The worry we heard as we launched the Pimco Total Return ETF was front-running. Bill has been a proponent of saying: "Well, show them everything."

And it hasn't been a problem so far.

Faber: The biggest problem managers have with transparency -- front-running -- is the wrong one. They should be more worried about justifying their fees. An investor can now say, "Wait -- that's all you've been doing? You've been charging me 2% for this?"

Bhansali: It's an "emperor's clothes" issue.

Dickson: The difference between active managers and benchmarks is not that managers are dumb. It is that their costs, on average, cause them to fall behind.

Faber: Indexes can be front-run, too. It may be just a handful of basis points for the S&P 500. But look at micro-cap stocks, where it is more pervasive.

Bhansali: In indexing, there are rules, they're disclosed, and you have no flexibility. Everybody knows what you are going to do, and when. So traders can get in front of you. If you are active, you have more flexibility. You don't have to do what people expect you to do. The cost of disclosing active management may be less than people believe, and I think a lot of index ETFs are paying more in terms of return drag than people realize.

Transparency is pretty crucial to the ETF market. Without it, the market can't make a reliable price.

Dickson: Transparency helps make self-dealing -- for instance, securities transactions that may benefit the fund company or authorized participant rather than the investor -- less possible. This gets back to a key question about active ETF development: Is there a balance between transparency that puts everyone on the same playing field but also alleviates concern about potential front- running harming investors?

Stephen, you see front-running as a big problem, and Eaton Vance has a proposal for a new type of product -- the exchange-traded managed fund, which would be less transparent than conventional ETFs.

Clarke: We think there's potential to revolutionize the way U.S. investors access active-fund strategies. Exchange-traded managed funds, as we envision them, would enjoy the cost and tax efficiencies of ETFs without the requirement for full daily portfolio transparency. We believe we can capture the previously mentioned 50 basis points or more of annual performance improvement over the same strategy in a mutual fund. This would come from eliminating flow costs and largely getting rid of transfer agency costs.

Tell us how it works.

Clarke: ETMFs would be a hybrid of a mutual fund and an ETF. They won't require full daily portfolio-holdings disclosure because they will use a methodology called net asset value-based trading, which was developed by the ETF innovator Gary Gastineau.

What will shareholders see in the middle of the day, if not the ETF's full portfolio?

Clarke: All bids and offers and execution prices will be expressed as a spread relative to that day's closing net asset value. You'll see shares bid for NAV, plus two cents. So it means the investor would pay two cents over whatever the closing NAV will be. You'll get an execution during the day, which is binding. Someone will have sold you those shares on our partner stock exchange, the Nasdaq.

You're saying I won't know my price when I make my purchase at noon? But I will know, at noon, where the price will be, relative to whatever the 4 p.m. price is?

Clarke: Exactly. NAV-based trading eliminates the need for full portfolio-holdings transparency because the market maker doesn't have risk to hedge during the day. When a market maker sells 1,000 shares of an ETMF, they have exposure to a 4 p.m. price. But they are not exposed to price movements between the time of that sale and 4 p.m. In an ETF, they are immediately exposed to the current value of the portfolio. So, because the market maker doesn't have risk to hedge, they don't need to know the holdings of the portfolio in order to hedge the risk.

It sounds like an important difference versus a conventional exchange-traded fund, and the fund manager can also cloak some trading activity.

Clarke: A creation/redemption basket would be disclosed every morning, just like an ETF, but the basket wouldn't necessarily be equal to the holdings in the portfolio. Portfolio managers would generally disclose all securities they hold but aren't trading. They would not disclose things they are in the process of acquiring. They might keep in the basket securities that they were liquidating, so that the market won't see the trading.

So if the manager spends days acquiring a stock, it might not be disclosed for days.

Clarke: Right. Most equity managers step into positions over a period of days. If trading were completed in one day, it wouldn't matter.

And it's purely up to the manager's discretion when something gets added to the published basket?

Clarke: That's right.

Dickson: Let's be clear -- there have been a lot of different structures proposed for nontransparent ETFs. None so far has gotten approved. Now, obviously, Eaton Vance has more optimism that theirs will. But there are a number of proposals that have been submitted to regulators.

So, Stephen, why is this proposal any likelier to succeed?

Clarke: We have been engaged in a constructive dialogue with the SEC over a period of time. We've been encouraged enough to file an exemptive-relief application, which we did at the end of March. Ultimate approval and timing are uncertain, and in the hands of the SEC.

Are there any strategies not suited for the ETF structure?

Johnson: Some of the most successful strategies on the equity side may never end up in this format. Look at Bruce Berkowitz, manager of the
Fairholme
fund (FAIRX). He is Morningstar's equity manager of the decade. And yet he is pretty much running from something as liquid as a traditional mutual fund, to say nothing of ETFs.

You're referring to his recent decision to close the fund to new investors.

Johnson: Berkowitz has suggested that he might even take it one step further and open something less liquid than a traditional mutual fund. We gave Berkowitz the honor because of superior time-period returns; if you look at the actual investor returns, it's clear that people bought the fund at precisely the wrong time. They bought when Berkowitz was saying, "Things are rich, I don't need any new money." Then they sold when Berkowitz wanted to buy, hand-over-fist.

A manager's hands are tied by investor flows.

Johnson: I can only hope that 10, 20 years out, costs are reduced, ETFs have cut some fat out of the system and put the money back in the investor's pocket. More broadly, the effect of the ETF will be to wash out the long tail of the mutual-fund industry that is populated by high-cost, index-hugging, low-to-no-value-added managers.

Faber: Low-to-negative-value added. Investors' biggest hurdle is themselves -- their own emotion. That's true, regardless of whether we're talking about indexing, active management, or any other approach in between.

Thanks, gentlemen.

The Biggest Hurdle

It might seem like a lot of complex detail, But the risk-free profit-making known as arbitrage trading is essential to the success of an exchange-traded fund. Here's what you need to know -- and why the mechanism benefits investors, but also keeps many active fund managers out of ETFs.

Mutual-fund pricing is comparatively easy: Those funds don't change hands during the trading session. Mutual-fund portfolio values, also called the net asset value, are calculated at the end of the day, governing where buyers and sellers transact. The NAV is simply the sum of the stocks and bonds it contains.

Because ETFs trade throughout the day -- as do the underlying stocks and bonds—pricing is trickier. An ETF's value is theoretically equal to its NAV, but can fluctuate in real time. This creates an opportunity for institutional investors: Monitor the market for arbitrage opportunities. And it is this activity that ultimately pushes prices together.

Suppose demand for an ETF drives its price to $50, but the sum of the underlying stocks lags at $49. A market-making firm can buy the underlying, individual stocks for $49 and exchange them for a newly created $50 ETF, pocketing the $1 risk-free profit. That's the essence of arbitrage trading. It's what keeps ETF prices from soaring above their NAV, as closed-end funds often do. Increased demand for an ETF simply causes the creation of more shares. The process also works in reverse, if an ETF's price falls below the NAV of its holdings.

For the process to work, an ETF needs transparency. Something called an intraday indicative value is published every 15 seconds to give market-making firms an idea of the hypothetical value of the ETF's portfolio all day. It's this transparency that is tough for active managers to swallow. If the entire market knows what a manager is buying and selling in real time, it's a bit like showing your hand in poker.

The dangers of telegraphing one's intentions to the market is the most oft-heard worry about actively managed ETFs. "We will not introduce an ETF of our traditional active mutual funds if the daily disclosure of portfolio holdings could be detrimental to existing shareholders," says a representative for T. Rowe Price, which has filed to launch active ETFs. -- B.C.

Waiting in the Wings

Actively managed ETFs have been slow to catch on as the industry warily weighs investor enthusiasm for cheaper access to strong management with the ability of those managers to buy and sell without copycats getting ahead of them.

One reason the field of active ETFs could change: The big boys are moving in. Fidelity has filed with regulators and is expected to launch its own within the year. Franklin Templeton and
T. Rowe PriceTROW -0.9237168899492262%T. Rowe Price Group Inc.U.S.: NasdaqUSD80.98
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have also filed and are evaluating their strategies. BlackRock's iShares just launched two quantitative ETFs that technically fall into the actively managed category. And others are sure to follow. -- B.C.